About the author

James Pethokoukis is a columnist and blogger at the American Enterprise Institute. Previously, he was the Washington columnist for Reuters Breakingviews, the opinion and commentary wing of Thomson Reuters.

A fascinating and instructive speech today on monetary policy from Ben Bernanke. The Fed chairman attempted to calm concerns about his open-ended bond-buying plan. Bernanke denied he was enabling Big Government by monetizing the debt. Bernanke denied his actions would lead to out-of-control inflation. Bernanke denied he was trying to influence the political debate.

Bernanke also outlined just how the plan would boost growth:

We expect these purchases to put further downward pressure on longer-term interest rates, including mortgage rates. To underline the Federal Reserve’s commitment to fostering a sustainable economic recovery, we said that we would continue securities purchases and employ other policy tools until the outlook for the job market improves substantially in a context of price stability. In the category of communications policy, we also extended our estimate of how long we expect to keep the short-term interest rate at exceptionally low levels to at least mid-2015.

That doesn’t mean that we expect the economy to be weak through 2015. Rather, our message was that, so long as price stability is preserved, we will take care not to raise rates prematurely. Specifically, we expect that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economy strengthens. We hope that, by clarifying our expectations about future policy, we can provide individuals, families, businesses, and financial markets greater confidence about the Federal Reserve’s commitment to promoting a sustainable recovery and that, as a result, they will become more willing to invest, hire and spend.

And in response to a question, Bernanke said legendary free-market economist Milton Friedman “would have supported what we are doing.” If that question wasn’t planted by Bernanke, it should have been. Many on the right are understandably concerned by the Fed’s unprecedented policy actions, fearing they will lead to dramatically higher inflation and economic instability.

But just as with the Great Depression, the Great Recession was the result of a failure of monetary policy, not markets. Friedman proved the former to be true in the 1930s and gave this advice on what to do in a modern environment marked by rock-bottom rates and no-growth. In the following quote, he was speaking about Japan in the 1990s but could as easily be talking about America today:

Defenders of the Bank of Japan will say, “How? The bank has already cut its discount rate to 0.5 percent. What more can it do to increase the quantity of money?”

The answer is straightforward: The Bank of Japan can buy government bonds on the open market, paying for them with either currency or deposits at the Bank of Japan, what economists call high-powered money. Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand their liabilities by loans and open market purchases. But whether they do so or not, the money supply will increase.

There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so. Higher monetary growth will have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately. A return to the conditions of the late 1980s would rejuvenate Japan and help shore up the rest of Asia.

Japan’s recent experience of three years of near zero economic growth is an eerie, if less dramatic, replay of the great contraction in the United States. The Fed permitted the quantity of money to decline by one-third from 1929 to 1933, just as the Bank of Japan permitted monetary growth to be low or negative in recent years. The monetary collapse was far greater in the United States than in Japan, which is why the economic collapse was far more severe. The United States revived when monetary growth resumed, as Japan will.

The Fed pointed to low interest rates as evidence that it was following an easy money policy and never mentioned the quantity of money. The governor of the Bank of Japan, in a speech on June 27, 1997, referred to the “drastic monetary measures” that the bank took in 1995 as evidence of “the easy stance of monetary policy.” He too did not mention the quantity of money. Judged by the discount rate, which was reduced from 1.75 percent to 0.5 percent, the measures were drastic. Judged by monetary growth, they were too little too late, raising monetary growth from 1.5 percent a year in the prior three and a half years to only 3.25 percent in the next two and a half.

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

Uncle Miltie, I think, would have supported the Ben Bernanke. Now, the Bernanke plan is not without risks. And I would be more comfortable if he specified what economic variable he was targeting as it would add further transparency and highlight the exact exit strategy or trigger point while adding to the policy’s effectiveness. And Washington, of course, needs to start implementing pro-growth, supply-side reforms while reducing spending and debt.

Discussion: (5 comments)

Given the fact that both Bernanke and Milton believed in slightly different versions of Keynesianism I am quite confident that their approaches would not have differed by very much. Sadly those approaches lead to ruin for the general economy, savers, and taxpayers.

I wouldn’t agree. Throwing more money around will not produce desired results in an environment where markets have no faith in the intention of the enterprise to use that money productively. The US Federal government has shown absolutely no sign that it intends to change it’s reckless fiscal habits.

Just because he would likely have agreed with QE doesn’t mean that he would have agreed with QE2 or QEternity. That’s like saying that just because Cheney said “deficits don’t matter” in 2002 when the deficits were around $100-200B means that he wouldn’t think that deficits an order of magnitude higher wouldn’t matter. Or that just because you like to breathe air with oxygen in it – you must ipso facto want to breathe pure oxygen.

From my reading of Friedman and Anna Schwartz, they would have supported QE1 to keep the money supply stable and prevent supply side deflation. However, the subsequent QE’s (to combat demand side deflation) do not reflect Friedman or Schwarz’s view. Anna Schwartz said as much when she criticized QE2.